Case Studies

Oil Levies: The Economic Implications

BACKGROUND

the United States. On the basis of your previous analysis, what differences would you expect to see between heating oil and gasoline prices in New York and in Rotterdam (the major refining center in northwestern Europe)?

The combination of weakening oil prices and the failure of Congress to deal with the budget deficit by cutting spending led some to see the possibility of achieving two objectives at once: (1) protecting U.S. oil producers from cheap foreign competition and (2) reducing the budget deficit. The solution was an oil-import fee or tariff. A tax on imported crude and refined products that matched a world oil-price decline, for example, would leave oil and refinedproduct prices in the United States unchanged. Thus, it was argued, such a tax would have little effect on U.S. economic activity. It merely represents a transfer of funds from foreign oil producers to the U.S. Treasury. Moreover, it would provide some price relief to struggling U.S. refineries and encourage the production of U.S. oil. Finally, at the current level of imports, a $5/barrel tariff on foreign crude oil and a separate tariff of $10/barrel-equivalent on refined products would raise more than $11.5 billion a year.

President Carter Lectures the Foreign Exchange Markets

At a press conference in March 1978, President Jimmy Carterresponding to a falling dollarlectured the international financial markets as follows:
Ive spent a lot of time studying about the American dollar, its value in international monetary markets, the causes of its recent deterioration as it relates to other major currencies. I can say with complete assurance that the basic principles of monetary values are not being adequately addressed on the current international monetary market.*

QUESTIONS
1. Suppose the tariff were levied solely on imported crude. In an integrated world economy, who will bear the burden of the import tariff? Who will benefit? Why? What will be the longer-term consequences? 2. If a $10/barrel tariff were levied on imported refined products (but no tariff were levied on crude oil), who would bear the burden of such a tariff? Who would benefit? Why? What would be the longer-term consequences? 3. What would be the economic consequences of the combined $5/barrel tariff on imported crude and a $10/barrel tariff on refined oil products? How would these tariffs affect domestic consumers, oil producers, refiners, companies competing against imports, and exporters? 4. How would these proposed import levies affect foreign suppliers to the United States of crude oil and refined products? 5. During the 1970s, price controls on crude oil but not on refined productswere in effect in

President Carter then offered three reasons why the dollar should improve: (1) the rapidly increasing attractiveness of investment in the U.S. economy due to high nominal interest rates, (2) an end to growth in oil imports, and (3) a decline in the real growth of the U.S. economy relative to the rest of the worlds economic growth.

QUESTIONS
1. How were financial markets likely to respond to President Carters lecture? Explain. 2. At the time President Carter made his remarks, the inflation rate was running at about 10% annually and accelerating as the Federal Reserve continued to pump up the money supply to finance the growing government budget deficit. Meanwhile, the interest rate on long-term Treasury bonds had risen to about 8.5%. Was President Carter correct in his assessment of the positive effects on the dollar of the higher interest rates? Explain. Note that during 1977, the movement of private capital had switched to an outflow of $6.6 billion in the second half of the year, from an inflow of $2.9 billion in the first half.
* President Canute, Wall Street Journal, March 8, 1978, p. 16.

3. Comment on the consequences of a reduction in U.S. oil imports for the value of the U.S. dollar. Next, consider that President Carters energy policy involved heavily taxing U.S. oil production, imposing price controls on domestically produced crude oil and gasoline, and providing rebates to users of heating oil. How was this energy policy likely to affect the value of the dollar? Explain. 4. What were the likely consequences of the slowdown in U.S. economic growth for the value of the U.S. dollar? for the U.S. trade balance? 5. If President Carter had listened to the financial markets instead of trying to lecture them, what might he have heard? That is, what were the markets trying to tell him about his policies?

Rescuing the Indonesian Rupiah with a Currency Board

On January 9, 1998, the Indonesian rupiah hit an historic low of 11,000 after a record low of 9,900 the previous day (see Exhibit A). It was down from 2,450 in July 1997 before the Asian currency crisis

began. Jakartas Stock Exchange Index plunged 12%. As news of Indonesias troubles spread, stock markets around the world were battered; the Dow Jones Industrial Average fell more than 240 points to 7560.74. The rupiahs plunge threw hundreds of banks and companies that had borrowed heavily abroad into bankruptcy (collectively, Indonesian businesses are estimated to be saddled with $74 billion in foreign debt). President Bill Clinton spoke to President Suharto and urged him to implement tough economic reforms to stop the deepening crisis from getting out of control. A senior Indonesian official said that Suharto agreed with Clintons assessment and promised to implement serious reforms. A senior U.S. economic delegation accompanied by the IMFs top two officials was sent to Jakarta. Investors took a dismal view of Indonesias prospects; from July 1997 when the Asian crisis began through the end of January 1998, the Jakarta Stock Exchange lost more than 84% of its value in dollar terms (see Exhibit B). The drop in the Indonesian stock market and the rupiah began the week before, when Suharto announced a draft budget that contained wildly unrealistic projections (GDP growth of 4%, inflation remaining at 9%, the rupiah doubling in value from

EXHIBIT A

The Rupiah Rides a Rollercoaster

2,000 Rupiah per dollar (inverted scale) 4,000

Rupiah exchange rate on July 1, 1997

Planned currency board rate 6,000 8,000 10,000 12,000 14,000 16,000 Doubts over Suharto's health emerge Indonesia releases unrealistic budget IMP threatens to cut off aid Speculation mounts that Suharto will adopt a currency board Suharto announces for 7th term

IMF and U.S. lobby against currency board Currency board may be dropped

Suharto agrees to IMF reforms

Suharto talks to Hanke about setting up currency board IMF may delay $3 billion disbursement Rumors that Habibie selected as Suharto's successor 2-Mar-98 5-Mar-98 10-Mar-98 13-Mar-98 22-Jan-98 27-Jan-98 30-Jan-98 4-Feb-98 9-Feb-98 12-Feb-98 17-Feb-98 20-Feb-98 25-Feb-98

1-Dec-97

4-Dec-97

9-Dec-97

12-Dec-97

17-Dec-97

22-Dec-97

26-Dec-97

31-Dec-97

6-Jan-98

9-Jan-98

14-Jan-98

19-Jan-98

EXHIBIT B G Indonesias Stock Market Index in U.S. Dollars:

January 1995March 1998
160 140 Index value (January 1, 1995 = 100) 120 100 80 60 40 20 0 12/30/94 2/28/95 4/28/95 6/30/95 8/31/95 10/31/95 12/29/95 2/29/96 4/30/96 6/28/96 8/30/96 10/31/96 12/31/96 2/28/97 4/30/97 6/30/97 8/29/97 10/31/97 12/31/97 2/27/98

Source: Morgan Stanley Capital International.

its current level, and a balanced budget based on projections of a 10% increase in non-oil tax receipts) and reneged on taking any of the tough structural reform measures it agreed to in October 1997 in return for a $43 billion IMF-led rescue package. Specifically, Suharto had promised to restructure the banking system, maintain a tight monetary policy, raise sales taxes, cut food, fuel, and electricity subsidies, end government funding of several huge, money-losing investments (including projects to design and manufacture a national car and a national airplane), and disband domestic monopolies, cartels, and special entitlements that had enriched his children and cronies. Most analysts viewed the budget as an attempt to maintain the status quo at a time that Indonesia was on the brink of disaster (private economists forecast a decline in GDP of 15% and inflation of 55%). They had hoped for austerity, a blueprint for the handling of cash-strapped and insolvent companies and banks, and repeals on foreign-ownership limits on property and financial institutions. Instead, Mr. Suharto pledged a 32% increase in government spending, including a 13 trillion rupiah increase in subsidies for fuel and food. The budget also allocated funds for the development by Suhartos eldest daugh-

ter of a new power plant on Java, even though Java already had an electricity surplus. In response, the IMF threatened to pull the plug on its $43 billion bailout program for Indonesia. IMF officials said they could understand Indonesias desire to place a high priority on social and humanitarian concerns in its budget but they criticized the government for doing so without making a goodfaith effort to implement the agreed-on structural economic reforms. Under the IMF-led rescue plan, Indonesia was required to achieve a budget surplus of 1% of GDP . However, IMF officials said they were willing to renegotiate the fiscal targets provided Indonesia implemented such reforms. The heightened tensions sent the rupiah plummeting and led to a sharp rise in food and other prices (see Exhibit C). Citizens began hoarding food, and fears of unemployment and social unrest were spreading. The threat of political instability was not taken lightly by its neighbors and others. Indonesia, with 200 million people, is the fourth-most-populous nation in the world. However, the income distribution is skewed, with the 4% of the population that is ethnic Chinese controlling about 60% of the nations wealth. In the 1960s, Indonesia was torn by bloody ethnic riots that led to a change of power, when

EXHIBIT C
200 Composite price indexes (January 1, 1995 = 100) 190 180 170 160 150 140 130 120 110 100

Inflation Accelerates in Indonesia

Consumer price index (food only) Consumer price index (all items)

Sep-95

Sep-96

Mar-95

Mar-96

Mar-97

Sep-97

Nov-95

Nov-96

May-95

May-96

May-97

Nov-97

Source: Central Bank of Indonesia

Suharto deposed his predecessor, President Sukarno. An estimated 500,000 Indonesians died in those riots, many of them ethnic Chinese. The long economic boom since then, with GDP growing at an average rate of 7% annually (see Exhibit D for growth rates since 1980), helped salve the ethnic antagonisms, but they always lie just beneath the surface. So it was predictable that with the economic hardships anti-Chinese riots became more common. Political stability also was threatened by Indonesias endemic corruption and the autocratic regimes resulting lack of popular support. Not to put too fine a point on it, President Suhartos regime was a kleptocracy, run for the financial benefit of his family and friends. They exploited to the full the opportunities for corruption and profit that their connections gave them. The scale of corruption was breathtaking; Suharto and his six children had an estimated net worth of $40 billion. Since Indonesias economic meltdown began in 1997, President Suhartos actions appeared designed to protect his familys financial interests and preserve his power rather than to promote the public good. With 7% real economic growth, enough prosperity reached the streets to keep the populace quiescent, if not happy. Authoritarianism, nepotism, and outright

corruption were tolerated as long as Suharto delivered the goods. But there was no reservoir of popular support to carry President Suharto and his regime through the price increases and other painful reform measures mandated by the IMF and necessitated by the current crisis. Moreover, there was no obvious successor to the 76-year-old Suharto, whose health was a question mark. On January 15, 1998, Suharto agreed to the sweeping economic reforms he had reneged on the week before. In return, the IMF agreed to begin disbursing funds to Indonesia. The rupiah and Jakarta stock exchange staged a modest recovery. Immediately after making these promises, Indonesia began pursuing contradictory policies that led to a sharp selloff in the rupiah. The central bank agreed to compensate depositors in 16 closed banks, while printing rupiah (ultimately more than 100 trillion rupiah) to keep the remaining 220 afloat. Rumors also began circulating that Suharto intended to appoint Bucharuddin Habibie, the minister of research and technology, as his next vice president and likely successor. These rumors drove the rupiah down on January 22, at one point to 17,000 to the dollar, largely because Mr. Habibie was the man behind many of Indonesias controversial spending programsprograms (such as the

Mar-98

Jul-95

Jan-95

Jan-96

Jul-96

Jan-97

Jul-97

Jan-98

EXHIBIT D
10% 9% 8% Real GDP growth rate 7% 6% 5% 4% 3% 2% 1%

Growth in Indonesia Real Gross Domestic Product: 19801996

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996
Source: International Financial Statistics, various editions.

attempt to build a national aircraft industry from scratch) whose financing President Suharto had just agreed to cut. Most controversially from the IMFs standpoint, President Suharto began to flirt with the idea of establishing a currency board that would tie the value of the rupiah to the dollar. He was introduced to the idea of a currency board by Steven Hanke, an American economist who pointed to the experiences of Hong Kong, Argentina, and other countries as demonstrating that such a system would stablize the currency and bring down soaring interest rates. By pegging the rupiah at a rate of 5,500 to the dollar, about twice its current value, President Suharto and his advisers became convinced that Indonesia could stop the rupiahs slide, rein in soaring prices, and restore the confidence of local and foreign investorsall without resorting to the IMFs bitter economic medicine. As word of the currency board spread, the rupiah soared in value. U.S., IMF , and EU economic officials, however, contended that a currency board is a quick fix that wont work. They argued that it could lead to disastrously high interest rates, further troubles for the Indonesian banking system, and increased social unrest. In addition, many currency traders believed that a currency board would soon fail, taking much of the banking system with it. The government was

guaranteeing all bank deposits, which it could not do under a currency board (because it could issue rupiah only if there were dollars to back them). Banks might suffer a run as depositors rushed to convert rupiah into dollars. Critics also complained that Suharto was only interested in a currency board because raising the rupiahs value would rescue his associates who have dollar-denominated debt. The IMF responded by delaying a disbursement scheduled for March 15. It then promised flexibility, especially on food and electricity subsidies. Most observers felt that the IMF had no choice: Between a poor harvest, massive unemployment, and soaring prices, there was a real fear of a humanitarian, social, and political disaster. During February, food riots and looting erupted in dozens of towns across Indonesia. Most of the violence was directed at shops owned by the ethnic Chinese. Students and other political protesters staged peaceful demonstrations against the government. Worse, Suharto appeared to have lost the support of many of Indonesias middle class, who tolerated him and his family as long as he delivered economic growth and a rising standard of living. Only the Indonesian armed forces appeared to stand in the way of anarchy. Its half million men were supposed to protect the state against internal threats as well as external ones. In practice the army

had done the presidents bidding. In return, its officers profited from the numerous opportunities for corruption that their pervasive presence in the countrys administration gave them. As long as Suharto retained the loyalty and support of the army, his grip on power was secure. However, if the social unrest got out of hand, the soldiers might decide that killing hundreds or even thousands of their countrymen to perpetuate his reign was not worth the personal cost. Such bloodshed would also make the army unpopular for years to come and threaten its privileged role in Indonesian society. To President Suharto and some of his economic advisers, the idea of a currency board promised a way out of the crisis without making the fundamental changes demanded by the IMF . They estimated that there were enough foreign exchange reserves to immediately restore the value of the currency to about 5,500 rupiah to the dollar. This jump in the rupiahs value would reassure investors that their Indonesian investments would retain their value. It also would reduce the inflation that was eating away at the purchasing power of the average Indonesians wages and would make it easier for Indonesian companies and banks to service their foreign debts (overseas borrowing gave them capital at about five percentage points less than at home). With the time bought with a currency board, Indonesias natural economic strengths could reassert themselves. It produces all its own oil and exports billions of dollars worth, and its manufacturing industry exports goods worth more than double its energy exports. Skeptics pointed out that what worried investors most was not inflation eating away at their wealth but that many of the countrys businesses and financial institutions could go bankrupt, or even that the country could descend into the chaos of the 1960s. At the same time, committing Indonesias reserves to a currency board meant they would be unavailable to pay for imports or debt service. The debt service alone was enormous, given the $140 billion that Indonesias public and private entities had borrowed abroad, much of it short term (for example, Indonesian companies had $43.2 billion in foreign debt due within one year). In addition, critics claimed that a rupiah fixed at 5,500 to the dollar would give the nations wealthy elite, including President Suhartos children and associates, a chance to trade their rupiah for dollars and deposit them overseas. Indonesias dollar reserves would disappear, interest rates would sky-

rocket, and the economy would be battered even more. Supporters, however, dismissed these concerns, claiming that money would flow into Indonesia, not out, thanks to new international confidence in the currency and country. Another option being discussedpossibly in conjunction with a currency boardwas a debt moratorium. A moratorium would presumably support the rupiah because debtors no longer would have to buy dollars to service their foreign debts.

QUESTIONS
1. What monetary policies could Suharto follow that would restore the rupiahs pre-crisis value? What problems would those policies face? 2. What were the costs and benefits of an Indonesian debt moratorium? 3. How did undermining the social contract between Suharto and the middle class affect the value of the rupiah? 4. How did a weak banking system affect the prospects for a currency board? 5. Should the IMF have withheld disbursements if Indonesia did not honor its commitments? What were the pros and cons? 6. Did the IMFs prescription for Indonesia make sense? Explain. 7. Why had Suharto found it so hard to implement the IMFs provisions? 8. What suggestions do you have for stemming the rupiahs slide and strengthening its value? 9. Did cuts in fuel and food subsidies make sense? 10. Should Indonesia have established a currency board? What considerations would you weigh in that decision? If you decide against a currency board, what alternative would you suggest?